Remarks of CFTC Commissioner Walter Lukken
U.S. Commodity Futures Trading Commission
Panel on Market Structure and Self-Regulation
Futures Industry Association Annual Conference
Boca Raton, Fla., March 18, 2004
In May of last year, our Chairman, Jim Newsome, announced that the Commodity Futures Trading Commission (CFTC) would undertake a review of self-regulation in the futures industry. This announcement predated the scandals in the corporate governance area that have led the debate on the securities side. Instead, the CFTC’s prescient review was driven by trends in the industry, including the demutualization of exchanges and the outsourcing of regulatory duties by exchanges.
The agency is in the final stages of our study. In a February press release, the CFTC noted that corporate governance would be a part of the ongoing study on self-regulation and that self-regulatory organizations (SROs) were immediately encouraged to re-examine their policies, procedures and safeguards in this area and publicize them to the market while the study was being finalized. The international regulators meeting yesterday on self-regulation was another step in this process and I am hopeful that we will incorporate some of the findings offered by our international counterparts.
When we complete our findings on self-regulation, I believe our agency’s recommendations should be driven by the mission that is provided our agency in statute: protecting market integrity, detecting and deterring fraud and manipulation, facilitating price discovery, and minimizing systemic risk to the system. Being mindful of these parameters will help us keep the recommendations tailored to these policy goals.
A goal of the Commodity Futures Modernization Act of 2000 (CFMA) was to transition our agency from a prescriptive regulator to an oversight agency, transferring many of the daily regulatory duties to the exchanges or their SROs. This transition was not done unilaterally but was directed by Congress with the belief that the proper checks were in place and the incentives existed to ensure that the public interest was being protected. If the CFTC in its SRO review finds that conflicts exist that contradict the public goals entrusted to exchanges, the CFTC has a legitimate role in resolving those conflicts.
Without passing judgment before the results of the study are known, I personally believe that self-regulation has its advantages. Self-regulation exists because exchanges have a natural vested interest in protecting their “brand name” and reputation. Self-regulation also provides benefits by employing people who understand the business and its participants better than anyone else and who have more of a stake in ensuring that it is run fairly and competitively.
In addition, SROs have a “proximity” to the markets that government regulators don’t have, and can often act more quickly than a federal regulator. There’s also a benefit to the government’s purse in having the industry police itself. Having SROs enforce standards can result in savings to taxpayers.
Of course, these potential benefits come with several caveats, including the fact that insiders have an informational advantage that can be used against competitors without the proper checks in place. Furthermore, there may be conflicts between the business side of the exchange, which might be hesitant to fine a revenue-producing member, and the self-regulatory side, which seeks to police the markets. These are hypothetical but possible scenarios that need to be addressed.
The statutory guidance in this area is thin. In the Commodity Exchange Act, core principles 14, 15 and 16 for designated contract markets touch on the governance of exchanges. Core principle 14 states that exchanges “shall establish and enforce appropriate fitness standards for directors, members of the disciplinary committee, members of the contract market, and any other persons with direct access to the facility.” This guideline keeps liars, cheats and felons off the exchange (what I call the “Don’t employ Tony Soprano” principle). It doesn’t provide much guidance beyond its commonsense foundations.
Core principle 15 states that exchanges “shall establish and enforce rules to minimize conflicts of interest in the decision making process of the contract market and establish a process for resolving such conflicts of interest.” This broad language does give the agency some authority to ensure that markets are identifying and addressing conflicts of interest among its leadership. This principle could serve as the basis for additional clarifications in this area.
Core principle 16 states that “[i]n the case of a mutually owned contract market, the board of trade shall ensure that the composition of the governing board reflects market participants.” For mutual exchanges, this memorializes what has been the practice for many years— that exchange leadership consists of a broad representation from its membership. A diverse board was thought to act as a check on unfair and discriminatory practices on the exchange.
To date, the CFTC has not adopted regulations for core principles 14, 15 and 16. One result of our study could be the development of “best practices” that, if implemented, could provide a regulatory “safe harbor” for exchanges wanting to ensure that they are meeting their corporate governance responsibilities.
For several months, I have been suggesting that a logical result of our study may be core principles for SROs. I believe our statute could be clearer regarding the objectives that are expected of self-regulatory organizations. Just as core principles have provided public guideposts for contract markets and clearing organizations, they could serve a similarly important function for self-regulatory organizations.
Self-regulatory core principles would provide exchanges and registered futures associations with concrete public directives while allowing them the flexibility to structure their organization to meet specific business needs. It also would offer the CFTC a template when its staff conducts compliance audits on such organizations.
Core principles could be accomplished through regulatory action or through legislative change in the upcoming CFTC reauthorization. The last reauthorization recognized that the regulatory approval for clearing houses and exchanges should be distinct and separate because the two entities represent separate risks and missions. I believe that this reauthorization will be a similar exercise for SROs and exchanges and as such, separate guidance and recognition will be necessary.
What might these core principles look like? One area for consideration will be minimizing the inherent conflicts of interests that exist between SROs and exchanges. This goal would likely incorporate greater independence of the SRO leadership and its decisions. Several exchanges have already made enhancements to their governance structure with this in mind.
Another theme of the core principles must be transparency. Just as federal agencies put proposals out for public comment and scrutiny, SROs, acting in a quasi-public function, must be transparent to the marketplace and the public in general. This brings legitimacy to their decisions and confidence to the manner in which they were reached.
Lastly, core principles on SROs must seek a balance between the enhanced independence of self-regulators and those whose job it is to run the exchange. Often times the views of these parties are aligned but not always. The key is to recognize when interests diverge and allow SROs enough independence to ensure that these markets are being properly policed.
Nevertheless, the “self” of self-regulation cannot be lost completely. Too much independence of leadership may result in perverse effects. Overly independent self-regulators may be so disengaged from the workings of the exchange that their actions inadvertently end up harming the market they were charged to protect. In addition, detached directors without industry experience may be so heavily reliant on exchange staff and management that they fail to offer a truly independent voice in the self-regulatory process. Neither one of these consequences is in the public interest and must be kept in mind when core principles are being developed.
I look forward to our agency’s release of its study in the coming months and to the ensuing debate on self-regulation and corporate governance.